How a Real Estate Cost Segregation Study Can Reduce Taxes and Increase Cash Flow
Since we’re coming up on tax season, it makes sense to address some tax-saving strategies used in real estate investing; depreciation tax strategies. There are essentially two ways that real estate investors can utilize depreciation tax strategies to reduce their tax liability; straight-line depreciation and cost segregation.
What is Depreciation?
Depreciation is defined as the decline in value of an asset over time taking into account for wear and tear. The term depreciation implies that there is a loss. A loss can actually be favorable when investing in real estate assets because it offsets your taxable income.
All real estate and the components that make up the real estate depreciates, lighting, fencing, sinks, roofs, toilets, etc. As a real estate investor, you can depreciate virtually everything – except the land value. The land is considered reusable, so cannot be depreciated.
The U.S. Federal tax code allows investors of real estate to take these tax deductions to reduce their current tax burden. This tax strategy is one of the greatest wealth-building strategies used by savvy investors.
What is Straight-Line Depreciation and What Are the Tax Advantages?
Straight-line depreciation allows for a decrease in the value of the asset that the investor can take as a deduction each year over a specified amount of time to offset their taxes depending on the asset type.
For example, investors in residential rental real estate properties can participate in a straight-line depreciation method taken over a 27.5 year schedule. Whereas investors in non-residential commercial real estate have a much longer depreciation schedule of 39 years.
What is a Cost Segregation Study and What Are the Tax Advantages?
Cost Segregation, in short, is depreciation that is accelerated.
The Tax Cut and Jobs Act (TCJA) incorporated a provision that allows investors to take what is called “bonus depreciation” on a qualified property of 100% in the FIRST YEAR for individual components of commercial properties. This approach rather than having incremental annual depreciation over a 27.5 or 39-year schedule as previously described in the straight-line depreciation method.
A quality cost segregation study, conducted typically by an engineering firm and tax professionals who have extensive knowledge in this area, determines each individual building component of personal property that makes up the real property assets can be separated from the real assets to be depreciated on an accelerated basis.
A cost segregation analysis avoids having to take the commercial buildings as a whole to depreciate over the longer 27.5 – 39 years and parses out tangible personal property assets and building components that have a shorter lifespan such as HVAC systems, parking lots, heating units, air conditioners, fences, etc., reclassifies them for IRS reporting purposes and allows for an accelerated depreciation timeline for those items.
The (TCJA) typically allows these certain personal property components that make up the asset to have shortened depreciation schedules of five, seven or 15-year class life. However, building owners of commercial property are allowed to deduct 100% of these qualifying components within the first year. This amazing perk is only available through the year 2022, so this is the last year you can take the accelerated deduction in one year.
Benefits of Cost Segregation
The benefit of a cost segregation study is that commercial real estate owners can accelerate their depreciation deductions through this bonus depreciation method. This can allow for tens of thousands to hundreds of thousands of dollars in depreciation that can be taken in that one year allowing for significant tax savings for the investors in these properties.
With this significant savings, it can dramatically increase cash flow to the passive investors not only for the current year that the bonus depreciation was taken but potentially for years to come if there are carryover losses.
Use of cost segregation studies is for a qualified improvement property only per IRS guidelines. This can help commercial property owners who have acquired commercial rental properties or commercial residential properties. Completion of a cost segregation study can cost upwards of $10,000 – $25,000 depending on the kind of real estate involved.
The value of investing in real estate such as a multifamily apartment community is that it will almost always appreciate which creates equity for the investors but at the same time allows investors to depreciate the building and its components which can generate enormous tax savings opportunities and increased cash flow at the same time.
Residential real estate such as affordable multifamily communities will always be a valued asset because it serves a basic human need – the need for shelter.
Multifamily housing has reliable passive income and profit potential because of the high demand for affordable housing. When you combine the outstanding tax benefits achieved through depreciation strategies with the increased returns that these tax strategies create, commercial multifamily assets will remain one of the most stable investment opportunities an investor can make.
Passive income real estate investments with significant tax savings are what create real wealth. With a real estate investment, you receive passive income but your tax obligation is reduced each year through these types of depreciation strategies that we talked about.
This is completely different than actively working every day earning income from a W2 wage job where you have no tax incentives to speak of and are taxed at the full whack. This is no wealth-building strategy, that’s for sure.
Real estate is a tangible asset that almost always appreciates and provides investors with increased equity, profits, and cash flow that is a hedge against inflation, that creates passive income while allowing you to save more of what you earn through depreciation tax strategies. And has no annual fees or transaction fees that you see with stock trading. No other investment opportunity provides you with these extraordinary wealth-building benefits.
The best time to invest and start building your wealth is now.
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